Here's What's REALLY In That Massive Fraud Allegation Against Sino-Forest

We've been writing a lot about Sino-Forest, the Canada-listed, Chinese forestry company whose stock plunged last week in the wake of a massive fraud allegation.

The allegation was brought by the short-sellers at a firm called Muddy Waters (run by Carson Block), and the stock plunge has cost famed hedge fund manager John Paulson hundreds of millions of dollars.

But if we're going to keep talking about it, it's worth examining what the allegation actually is.

As Bernard Madoff reminds us, when an established institution commits fraud, the fraud can become stratospheric in size. Sino-Forest Corp. (“TRE”) is such an established institutional fraud, becoming massive due to its early start, luck, and deft navigation. At nearly seven billion dollars in enterprise value, it will now end.

TRE started humbly – as a fraudulent company going public on the Toronto Venture Exchange via reverse takeover (“RTO”). Sixteen years later, Muddy Waters would be exposing its US- listed imitators – companies such as RINO, DGW, ONP, and CCME. It seems impossible that a Chinese RTO coming public in 2010 could ever get to where TRE did. But for many years, TRE sat barely noticed on the Toronto exchange. It was committing fraud from the very beginning; but, there were not enough similar frauds to raise investors’ awareness.

In the beginning, according to Muddy Waters, the alleged fraud was pretty straightforward.

Basically, it claimed to have a fast-growing and profitable JV in China when in reality -- according to the report -- there really wasn't anything there. On the Toronto Venture Exchange, a company dealing in an allegedly made up Chinese JV wasn't really going to get anyone's attention.

However in 2003, says Muddy Waters, it got much more aggressive about growing the fraud, and this is where it gets interesting.

Basically, the company operates through a series of "AIs" (authorized intermediaries).

Supposedly, the intermediary would buy lumber, deliver them to a chipping facility, collect the woodchips, and sell them to an end user, and then pay Sino-Forest a cut of end profits.

Immediately you ask: For what service did TRE deserve a cut of end profits, given that it was (supposedly not logistically involved in the process.

As shown in the diagram (from Muddy Waters below), TRE assumed risk for the whole operation when the lumber was at the chipping facility, but before it turned into chips.

From Muddy Waters:

Essentially, TRE’s assumed risk was that a meteor would destroy the wood while at the AI’s facility (assuming that the contracts lacked force majeure clauses). For this invaluable service, the AI paid TRE a fee on a “net basis after withholding of applicable taxes by the AI.” In other words, there was no tax documentation that can be used to confirm whether TRE actually received any money in this way.

Believing that TRE actually generated substantial revenue this way strikes us as akin to believing in the power of diving rods to find precious metals. However, TRE was able to apply the same principles to a model that allowed it to raise billions of dollars more. The model is dealing in standing timber.

Now ast FT Alphaville clarified in its explanation the purpose of using this convoluted business model is that it allowed Sino-Forest to claim that it was the AIs that paid VAT taxes in China, thus throwing auditors of the scent. VAT receipts are apparently key to Chinese auditing.

All that being said, Muddy Waters believes this whole thing is fictitious, and that no AIs (authorized intermediaries) even exist.

What's next is the claim that after fabricating this wood chipping operation, Sino-Forest basically got in the business of doing the same thing, but with standing timber.

TRE claims to have purchased under various master purchase agreements since 2006 timber costing $2.891 billion. Smoking gun evidence shows that TRE overstated purchases from the Yunnan agent, Gengma Dai and Wa Tribes Autonomous Region Forestry Co. Ltd.48 (also known as Gengma Forestry Co. Ltd. – see Appendix D1) which appears to be a legitimate agent, by approximately $800 million.

The value of purchases made under Yunnan master agreement is overstated by approximately $800 million. TRE announced in March 2007 that it had entered into a master agreement to purchase up to 200,000 hectares of plantation trees in Lincang City, Yunnan Province.49 (Note that Gengma County is a sub-division of Lincang City.)

This is where it gets really complicated -- and where Muddy Waters shows off its sheer legwork in attempt to expose this fraud.

Muddy Waters does this by comparing official documents with reality on the ground. Again, it gets really technical (and other parts are even moreso), but it offers a taste of exactly how Muddy Waters went about its research and alleged debunking process.

The approval letters state that TRE has entered into an agreement to acquire 6,667 ha (300,000 mu) of forest plantation in Lincang City. TRE acquired 75,000 mu in 2007 from Gengma Forestry Co. Ltd. The Yunnan agent told us that after TRE completed this purchase, it helped TRE acquire another 13,333 ha (200,000 mu) in the nearby Lincang counties of Mengding and Cangyuan. Below is a photo of the agent’s office that our field agent took.

Lest there be any doubt that the approvals omitted the other 160,000 ha that TRE claims is covered under the agreement, information about the local economy and forest industry make it clear that TRE did not enter into agreements to acquire such a large amount of forest, and at such a high per unit price.

The 2008 Work Completion Report states that Lincang City’s forest industry output was approximately $380 million (RMB 2.6 billion). The report also states that the forestry business received only $32 million in foreign investment in 2008. TRE would have represented 80% of the forestry GDP for the entire city – let alone county. It would have invested approximately substantially more than the city reports in foreign investment in the industry. (Again, their main operation is in Gengma county, which is a sub-division of the city.) In the 2009 Report, the industry output reached approximately $440 million for the entire city. More interestingly, the report states that the city only issued forest rights concessions of 267 ha (4,000 mu) for the year. The 2010 semi-annual report states that as of 2010, Lincang City had issued forest rights concessions of 45,526 ha, valued at approximately $50 million. From these numbers, we can see that TRE is overstating the per hectare cost by about four times. Below is the calculation based on Lincang City’s numbers:

The sheer scale of TRE’s claims regarding its Lincang City, Yunnan transaction contradict reality. The Bureau of Statistics of Lincang stated the GDP of Lincang City was $3.1 billion in 2010 (Appendix D7). This contract alone would have caused local GDP to grow to four billion dollars, making Lincang the next Shenzhen.

From our fieldwork, we were told that Gengma County’s 2010 total GDP was only $475 million. If TRE were to be believed, it would have been the vast majority of the entire economy of the county.

Got all that?

There's just no way this particular forestry transaction fit into the area's economy.

Muddy Waters walks through several other instances of seemingly implausible forestry purchases.

And the report touches on other issues to. It argues that Sino-Forest's domestic capital needs are much bigger than the amount of capital Sino-Forest has actually brought back into China (because of China's famous capital controls, all outside money needs to be registered before it can be converted into RMB).

Anyway, ultimately the firm concludes that the agents (ostensibly independent companies) through which Muddy Waters operates do nothing except funnel money back to parties related to Sino Forest, and that's where in the process, TRE "steals the money" in Muddy Waters' words.

Finally, it's a ponzi -- as Muddy Waters puts it -- because it has raised $2.9 billion through the capital markets -- more and more each time -- without ever having paid out a cent.

So, bottom line, these are the allegations from Muddy Waters:

Sino-Forest always started off as a fraud, though originally a modest one.

Eventually it designed this wood-chip scheme that allowed it to claim that it was collecting all these revenues merely for keeping risk at one point in the supply chain.

The real point of this scheme was, however, to explain why it didn't have VAT receipts.

It then basically mimmicked the model, but with wholesale timber, claiming that third parties were buying and selling timber, and kicking back money to Sino-Forest.

In fact they were only dealing in a fraction of the forest they claimed to be, as Muddy Waters "proves" by showing the volumes they were engaged in were unfeasable.

These third parties sent a lot of money to related parties to Sino-Forest.

Sino-Forest has raised over $2.9 billion to fuel this operation.

Of course, this is all just one half of the story. The company hit back today, posting documents that it claims corroborates its assets. And it's not easy for a third party to really adjudicate the technical aspects of Chinese forestry -- which is really where a lot of the alleged fraud is supposedly proved.

Our best guess is that the next stage will involve some statement of finding from the company's auditors Ernst & Young out of Canada (that's a whole nother aspect of this story that we haven't even touched on in this summary, or investors will get further information from Jaako Poyry -- forestry consultants supposedly employed by Sino-Forest (again, a completely different facet).

This could be a long process. In the case of CCME -- another Muddy Waters "victim" -- the stock was halted in mid-March and didn't trade again until mid-May, at which point (after the resignation of its auditor) it moved from the NASDAQ to the pink sheets. That stock currently trades at $1.27/share, down nearly 95% from its high earlier this year.